Previously published on April 25, 2022 in
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By Milton Ezrati, Chief Economist at Vested

European Central Bank (ECB) President Christine Lagarde is playing an even higher-risk game than Federal Reserve (Fed) Chairman Jerome Powell. Each clearly wants to deal with the accelerating inflation confronting their respective regions, but neither wants to risk a recessionary consequence. In their efforts to balance one risk against the other, both seem likely to fail and will get both inflation and recession.

In the United States, the Fed has only just begun to take an anti-inflationary heading. In response to an 8.5% rise in the cost of living, the worst in over 40 years, Fed policy makers have taken baby steps. They have halted their practice of buying securities directly on financial markets, what central bankers call “quantitative easing.” They have also made small steps toward raising interest rates from near zero, adding 0.25 percentage points to the target federal funds rate to bring it to 0.5%. Other central banks, notably in Canada and New Zealand have taken similar steps.

The ECB has not even gone this far. In the face of inflation of 7.5%, Lagarde has talked about ending the bank’s quantitative easing program, perhaps in May, perhaps not until September. Interest rate increases, she has stated, will wait until late this year, if then. Lagarde explains her lack of action by drawing two distinctions to the American situation. Europe, she asserts, is less far along in its post-pandemic recovery than America, and its economy is much more vulnerable to the sanctions imposed on Russia.

In one context, Powell’s caution and Lagarde’s reluctance to do much at all are easy to understand. No policy maker wants to impose the kind of restraint that might precipitate recession or even an economic slowing. But unless they take the risk and move a lot further and a lot faster, neither has a chance of quelling the intensifying inflationary pressures confronting them. Their timid postures might be justified if the inflation were, as some in authority continue to assert, simply the transitory result of post- pandemic supply-chain problems or the immediate result of the sanctions placed on Russia, but they are not. Supply-chain matters and sanctions have indeed contributed to inflationary pressures, but today’s inflation also has much deeper and more fundamental roots that will make it stubborn and hard to quell.

These more significant and lasting pressures reflect years of misguided fiscal and monetary policies in both Europe and the United States. For over a decade now, governments on both sides of the Atlantic have pursued extremely stimulative fiscal postures that have created extremely wide budget deficits. Each continent has faced a succession of crises that seemed at each stage to require such policies, but the pattern over this long time has nonetheless created economic imbalances. Worse from an inflation standpoint, the authorities on both continents have used extremely expansive monetary policies to finance these fiscal policies. The Fed in the United States, for instance, has used new money creation to purchase some $5 trillion in government debt during this time, $3 trillion in just the last couple of years. This is the modern equivalent of financing government by running the printing press, a classic prescription for inflation.

Against the staying power of this kind of inflationary pressure, central bank actions to date look weak to say the least. Especially since inflation has had a chance to build a powerful momentum during the past year or so, Lagarde’s recently voiced concern about undershooting inflation targets sounds nothing short of ridiculous. She says that she is worried about how restraint might cause economic stagnation resulting in inflation below the 2% target. That is a long way below the actual 7.5%. Such a result is, of course, possible. But it is hardly likely. Contrary to such distant possibilities, more realistic thinking might consider how much restraint it will take over how long the ECB might need to quell such an embedded inflationary pressure.

Nor can a less aggressive monetary approach save Europe or the United States from recession. Left unchecked the inflation on its own will have such distorting economic effects that it will precipitate stagnation – stagflation — and ultimately an economic downturn. The uncertainties engendered by price pressures will for one stymie business investment in productive projects that create growth and jobs. Inflation will also divert what investment monies are available to inflation hedges, such as art and real estate speculation, and away from productive, job creating investments.

Workers, even if they can get wage hikes, will see a rising cost of living destroy the buying power of their incomes. The ultimate downturn may take longer to develop than one resulting from monetary restraint, but it would arrive nonetheless and probably last longer and be more severe than anything risked by prompt and effective anti-inflationary monetary action.

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